The presence of inflation that is uncomfortably higher than the Fed’s stated policy goal of roughly 2.0% fundamentally alters how the Fed can conduct monetary policy.
The rise in short-term interest rates, and more importantly, the sharp increase in market expectations of further tightening, has been the primary driver of recent market turmoil.
The corresponding increase in discount rates has led to a fundamental repricing of valuations and a sharp rotation away from stocks with relatively high implied growth rates into stocks with relatively low implied growth rates.
Performance of VC-backed companies that have recently gone public suggest there has been a huge dislocation in valuations between private and public markets that we think will be hard to ignore any longer.
If the market is correct, and short-term rates do indeed increase by 200 basis points by year-end, this would result in the average interest coverage ratio for recent buyout deals falling to 2.2x, assuming EBITDA is unchanged. For future deals, this means that leverage, which has magnified positive returns in recent years, or valuations will need to come down.